MONETARY THEORY

Monetary Theory explains the role of money in the economic

system. With the existence of monetary theory, the workings
of the economic system are better understood. For instance,
why do prices increase ? Why does production decline ?
These are very familiar economic problems whose cause are
clearly related to the use or value of money.

THEORIES WHICH EXPLAIN THE CHANGES IN

MONEY.
Transaction Theory
Cash-balance Theory
Income Theory
The First two Theories stress the value of money as the main
determinant off economic activities while the income theory
emphasizes the flow or use of money and not its value which
causes changes in economic activities.

TWO VIEWPOINTS OF THE MONETARY THEORY

Finance charge
includes interest, fess,
service charges
discounts, and such
other charges incident
to the extension of
credit as the Monetary
Board of The Central
Bank of the Philippines
may by regulation
prescribe.

Creditor means any

person engage in the
business of extending
credit who requires as an
incident as the extension of
credit, the payment of a
finance charge.

INFORMATION TO BE FURNISHED BY THE CREDITOR

1.

The cash price or delivered price of the property or service to be acquired;

2.

The amount, if any, to be credited as down payment and/or trade-in;

3.

The difference between the amounts set forth under clauses (1) and (2);

4.

The charges, individually itemized, which are paid or to be paid by such

person in connection with the transaction but which are not incident to the
extension of credit;

5.

The total amount to be Finance.

6.

The finance charge expressed in term of pesos and centavos; and

7.

The percentage that the finance charge bears to the total amount to be
finance expressed to be simple annual rate on the outstanding unpaid
balance of the obligation.

THE USE OF MONEY

The income theory claims that the use if money can have
great influence on economic activities even though its value
does not change. Income theorists believe that their theory is
better than the money-of-value because it clearly shows how
the flow of income or money causes economic changes.

As to use of money, people have several options.

They can spend

Save their money.

Savings available for investments or just keep their money in their
houses. Such decisions affect the economy in terms of investments,
employment, production and consumption. For example, when saving
are greater than investments, it means the resources of the economy
are not fully used. There is less production, less employment, less
income, less consumption and so on.

Income theorists believe that the value-of-money theories

were only suitable during the early years when the economy is
highly competitive, and when prices were determined by
demand and supply forces. Such economic conditions are
adequately explained by the theory that price level changes in
accordance with the changes in the quantity of money and its
velocity.

THE TRANSACTIONS THEORY

The transactions theory states that the value of
money is determined by demand and supply in a
given market at a given time. The 3 determinants of
money value are;
The average quantity of money available.

Average Velocity
Volume of trade

If there is an increase in the supply of money without a

change in the demand for money, its value falls. This
means there is an increase in price. On the other hand,
if there is an increase of demand without a change in
supply of money, its value rises or price level goes
down. It can be stated therefore that other things
remaining equal.

TRANSACTIONS IN THE EQUATION OF EXCHANGE:

PT=MV
P

is the general price level or average price level paid for goods like rice,
shoes, lumber etc.

is the average quantity of money available through-out a year or other

period of time.

is the average velocity of money in the same period or the same number
of times the money is spent in one year.

is the volume trade, number of transactions or the total number of goods,

services, and financial instrument that are brought in the market in a given
period.

PT=MV
P= MV/T
Assuming that M=1,000,000; V=18; and T=12,000,000
what will be the P ?
LETS COMPUTE

M= 1,000,000; V=18; T=12,000,000

P

= MV/T

= 1,000,000(18)/12,000,000
= 18,000,000/12,000,000
= 1.5
Thus the equation PT=MV;
1.5(12,000,000) = 1,000,000(18)
18,000,000 = 18,000,000

NOW CONSIDERING THE ORIGINAL ASSUMPTION,

WHAT WILL BE P IF THERE IS A CHANGE ON EITHER
THE FOLLOWING;

1. M is increased by 200,000
2. V is increased by 6

3. T is decreased by 2,000,000
4. M is increased by 300,00

5. V is decreased by 6
6. T is increased by 6,000,000

THE ANSWERS FOR THE ABOVE PROBLEMS ARE AS

FOLLOWS:

1. M is increased by 200,000

P is 1.80

2. V is increased by 6

P is 2.00

3. T is decreased by 2,000,000

P is 1.80

4. M is decreased by 300,00

P is 1.05

5. V is decreased by 6

P is 1.00

6. T is increased by 6,000,000

P is 1.00

CASH BALANCE THEORY

The supply of money refers to the cash-balances or money holdings of the people, not the
velocity of money as recognized by the transaction theory.

CASH-BALANCE EQUATION OF EXCHANGE

M=KTP
M

is the average quantity of money available.

is the production of the years volume of trade over which the people to decide
to retain their purchasing power in terms of cash balances.

is the volume of trade, total quantity of goods, services, and property rights
that are bought in a given period of time.

is the average price of goods, services and property rights.

P=M/KT
M, the numerator is the supply of
money and KT, the denominator is
the demand for money.

ASSUMING THAT M= 1,000,000; K=1/6; AND

T=12,000,000. WHAT WILL BE THE P ?

P= M/KT
P=

1,000,000_
1/6(12,000,000)

P=

1,000,000_
2,000,000

P=

.50

Thus, the equation M=KTP will be:

1,000,000 = (.05)(1/6)(12,000,000)
1,000,000 = 1,000,000

QUANTITY THEORY OF MONEY RE-EMPHASIZED

The quantity theory of money states ta=hat other things remaining
unchanged, a change in the quantity of money will result a
proportional change in the price level (Thomas,1957). Stating it in
another way, the quantity theory of money expresses the view that
changes in M cannot cause changes in V and T. However, changes
in M will result in proportional change in P. This point has been
described in the Transactions Equation (MV=PT). Also, in its
modified form, the equation is now expressed in a formula
PT=MV+MV where M refers to the amount of money substitutes
(Credit Instruments), and V refers to the velocity (rapidly) of money
substitutes.

M=1,000,000; V=18; M=1,000,000; V=18; AND

T=24,000,000.

P= MV+MV/T
P= 1,000,000(18)+1,000,000(18)/24,000,000

P= 36,000,000/24,000,000
P= 1.50

Income Theory

The income theory maintains that changes in the economy are not influenced
by the changes in the value of money or price levels. The theory stresses the production
of new goods, and the speed of spending factor of incomes (wages, rent, interest and
profits) for products. It explains the working of the economic system through the
interactions of the various aggregates like investments, income, consumption and
savings.
The value of money according to the theory is determined by the savingsinvestments relationship. Savings (S) Investment (I)
S = I (No movement on the price level)
S > I (Downward pressure in price level)
S < I (Upward pressure in price level)
Savings refers to supply of money and investment to the demand for money.

The theorist contend that the changes

in price do not depend only on savinginvestments relationships but also on
the availability of the idle factors of
production, and the degree of control
made by the enterprisers in the various
fields of industry. (Kent, 1970)

FUNDAMENTAL EQUATION
John Maynard Keynes
Y=C+I
Y

aggregate the income

being the amount spend for goods for consumers

the amount spent for, and consequently receive in the production of

investments goods.

Y C = S where S being the amount of savings left between the aggregate

income less that amount spent for consumption; Y = C + I; Y = C + S; I = Y C.
Therefore, S = I.

HOW ABOUT WHEN SAVINGS IS LESS OR

GREATER THAN THE INVESTMENT ?

Firstly, if savings is equal investment (S = I), Y is stable. (Thomas,

19957) to illustrate, lets assume that Y = 20,000; S and I are Both
20% of Y.

Y = 20,000

1st Pd.

Utilized

2nd Pd.

Expenditures
C = 16,000
I = _4,000_
Y = 20,000

S = 4,000

Utilized

3rd

Pd.

Expenditures
C = 16,000
I = _4,000_
Y = 20,000

S = 4,000

Secondly, if savings is less than investment, (S < I), Y rises. To Illustrate,

assume that Y= 20,000; S is 10% and I is 20% of Y.
1st Pd.

Y = 20,000

Utilized
2nd

Pd.

Expenditures
C = 18,000
I = _4,000_
Y = 22,000

S = 2,000
Dishoarding and New Bank
Credit 2,000

Utilized
3rd

Pd.

Expenditures
C = 19,800
I = _4,400_
Y = 24,000

S = 2,200
Dishoarding and New Bank
Credit 2,000

Thirdly, if savings is greater than investment (S > I) Y falls. To Illustrate, assume that Y =
20,000; S is 20% and I is 10% of Y.

1st Pd.

Y = 20,000
Utilized

2nd Pd.

Expenditures
C = 16,000
I = _2,000_
Y = 18,000

S = 4,000
Cash Hoard 2,000 and
Repayment of Bank Loan

Utilized
3rd

Pd.

Expenditures
C = 14,400
I = _1,800_
Y = 16,000

S = 3,600
Cash Hoard 1,800 and
Repayment of Bank Loan